Author: B2B

Maritime India Summit 2016 (MIS 2016) is a maiden flagship initiative of the Ministry of Shipping.

Maiden = First time ever. First time ever translates to a higher probability of it finding its way in the IAS Prelims this year.

Why do we say so? If you wrote the IAS prelims in 2014, you would remember the National Biodiversity Express initiative launched by GoI that year and how a few questions from E&B found their source in the released pamphlet. So, no harm in giving this a look, right?

Focus Area for intervention which are important for your review:

• Port Modernization
• New Port Development
• Inland Waterways
• Green Initiatives in Ports

Maritime Potential of Indian States

If you are loath to read through the commentary, make sure you go through this infographic (in desktop mode – click on the pic to enlarge) & make quick notes.

#1. Port Modernization

India has 12 Major Ports, administered by the Central Government, and around 200 notified Non-Major Ports, administered by the State Governments. In 2014-15, out of the 200 Non-Major Ports, 69 ports were reported to have handled cargo traffic.

• Kandla was the last major port built by India – 1950
• India plans to add 8 major ports to this list of 12. Source: ET

Fodder points – 

1. The infrastructure sector, particularly the Maritime Sector, is expected to grow significantly with the increase in international and domestic trade volumes
2. Since about 95% of India’s trade by volume is via the maritime route (Source : NTDPC), there is a continuous need to develop India’s ports and trade related infrastructure to accelerate growth in the manufacturing industry and to aid the ‘Make in India’ initiative.

#2. New Port Development

Why is there a need you may ask?

1. Capacity Saturation – Ports such as JNPT, Paradip have limited capacity to expand and are saturated with traffic
2. Non-availability of Ports – There are few specific stretches along the coastline which do not have an operational port. In absence of the port at such locations, the cargo is forced to travel longer distances to use alternate ports
3. Strategic Locations – The southern tip of India is optimally located as it falls under the East-West trade route. However most of transshipment cargo from India is dependent on ports of Colombo and Singapore. Hence, we need to fulfill this need

Potential Projects? Greenfield major ports to be developed at

• Vadhavan (Maharashtra) – MOU was signed by JNPT. Read here.
• Sagar Island (West Bengal) – This island, also known as Gangasagar or Sagardwip, is a place of Hindu pilgrimage
• Paradip Satellite Port (Odhisha) – What is a satellite port?
• Cuddalore/Sirkazhi (Tamil Nadu)
• Machilipatnam/Vodarevu

Question: Find out the difference between Greenfield and Brownfield projects. A term often used in PPP parlance. 

#3. Inland Waterways

India has an extensive network of inland waterways in the form of rivers, canals, backwaters and creeks. Of the total navigable length of 14,500 km, 5200 km of the river and 4000 km of canals can be used by mechanized crafts.

India has recognized 106 waterways of which 6 are declared as national waterways – 

#4. Green Initiatives in Ports

• Solar and wind based power systems at all the Major Ports across the country
• What’s the plan? Solar energy capacity at 8 major ports + Wind energy capacity at 3 major ports

Key initiatives (Fodder points):

• The Ministry of Shipping has recently introduced an incentive scheme under which the Ministry will share up to 50% of the total project cost that promote the use of green energy
• Anti-fouling System Convention of International Maritime Organization has been incorporated in the Merchant Shipping Act, 1958
• Use of bio-diesel at Haldia Dock Complex

Sources: http://www.maritimeinvest.in 

If you have time and you want to venture out and see the other heads of developments, do go and visit the website, especially carved out for this summit. 

This marathon article follows article on inflation and monetary policy. If you haven’t read them, read them first by clicking here. Inflation explained, monetary policy explained. This article is very important for exam and essential to understand subsequent economic survey cahpters.

In the last article we saw role of RBI in controlling money supply and interest rates and thus influencing growth- inflation dynamics. Government similarly affects this dynamics through its policy known as fiscal policy.

What is fiscal policy?

fiscal policy is the use of government revenue collection (mainly taxes but also non tax revenues such as divestment, loans) and expenditure (spending) to influence the economy.

Fiscal policy thus contains essentially two components-

Revenue Collection- (primarily taxation)- Govt collect taxes which are of two types

Source- Quora

1. Direct tax -A direct tax is generally a tax paid directly to the government by the person on whom it is imposed. Eg-. Income tax<your income, you pay tax>, corporation tax<Corporate profits, they directly pay tax>, wealth tax<your wealth, you directly pay tax>, capital gains tax<value of your asset increases, you pay tax>, securities transaction tax<you trade, you pay>

2. Indirect tax-An indirect tax is indirectly paid by consumers. Govt taxes goods and services # manufacturer/ seller/ service provider pay the taxes # he increases the prices to recover taxes # indirectly consumers end up paying taxes. In effect, tax is shifted from one taxpayer to another, by way of an increase in the price of the goods and services. Eg. Excise duty<union tax on manufacturing>, custom duty<union tax on imports and exports>, service tax<union tax on services>, sales tax or VAT<state level tax on sale of goods, that’s why price of petrol is different in all the states>, central sales tax<tax levied by union but given to states on interstate movement of goods>

Q. What Is Minimum Alternative Tax (MAT)? Is it a direct or indirect tax? What is the rationale for imposing it?

Indirect tax is generally considered regressive in nature as tax remains the same no matter how much you earn. So, for instance, if tax on diesel is 20%, a poor farmer would have to pay the same tax to run his tube-well as Ambani has to pay to drive his Audi. On the other hand, in direct taxes, less you earn, less you have ti pay<Brackets in income tax>.

Of course, governments try to make indirect tax structure a bit less regressive by taxing luxury products more. For instance, taxes on SUVs are higher than taxes of small cars. Also, govt by way of higher taxes try to shift consumption away from some product such as cigarette, tobacco etc.<sin tax>.

What would happen if govt increased taxes?

When government increases taxes, it basically leaves less money in the hands of people # less money # less consumer demand # apply demand supply principle # less demand for goods # prices fall # corporate will delay investment # job loss # slowdown in the economy

As we saw when RBI raises rates or sucks out liquidity through open market sales of government securities, it tightens money supply and reduces demand resulting in prices fall. It is said to be following dear or contractionary monetary policy.

Similarly when government raises taxes, it reduces consumption demand and it is known as contractionary fiscal policy. On the other hand when government slashes rates to stimulate consumption to kick start the economy, it is known as expansionary fiscal policy.

Expenditure (spending)- Government spend money which also provides demand to the economy. If government decides to spend more by borrowing, it increases aggregate demand and it is known as expansionary fiscal policy.

Basically contractionary policy- increase taxes, slash spending is followed when inflation is high to bring down demand and thus cool down prices and expansionary policies to pump prime the economy by creating the demand through decreased taxes and higher spending.

Estimates of spending and taxation are presented in budget which also mentions various deficits like fiscal deficit, revenue deficit, effective revenue deficit. Want to know more about them, click here

Plan v/s non plan expenditure

Plan expenditure– expenditure on schemes and projects covered by the five-year Plans (road construction, railway line construction etc.)

Non-plan expenditure: Ongoing expenditure by the government not covered by the Plans <routine expenditure to run the govt>. Eg. Interest payment, Subsidies, salaries, pension, defense expenditure etc.

Please note that bot plan and non plan expenditure includes revenue and capital expenditure. It’s not that the plan expenditure is equivalent to capital expenditure while non plan is revenue expenditure. To know the difference b/w revenue and capital expenditure, click here

Q. Plan v/s non plan classification of expenditure should be scrapped. Comment.

Budget is an important part of fiscal policy as revenue and expenditure statements are presented during the budget. Let’s understand in brief, where all the revenue comes from and where all the money goes.

We can clearly see, among non debt creating receipts (not borrowings), maximum earning is from corporate tax followed by income tax.

Always remember these facts on revenue and expenditure side by heart

• direct taxes> Indirect taxes
• Corporate tax>Income tax>Excise>Service tax>custom
• Non plan expenditure> Plan expenditure (more than double)
• Interest payment>>subsidies and defense  <subsidies and defense are almost equal. Every year including this year defense is budget higher amount but eventually, subsidies turn out to be higher during revised estimates>
• Food subsidies>> Fertilizer subsidies >> Fuel subsidies

When government reduces its fiscal deficit, it is known as fiscal consolidation. Learn everything about fiscal consolidation here

Clearly it can be achieved in two ways, reduce spending or increase taxes or combination of two. Here we discuss one component of spending known as subsidy in some detail. Everyday we read about subsidy rationalization, cutting or increasing subsidies and passionate arguments on both sides.

So, What is subsidy?

In a layman’s term, it can be understood as converse of a tax in that using taxation government takes money from consumers while subsidy in effect transfer money from government to consumers.

For instance, taxes on grain would increase their market price from say 10 rs a kg to 12 rs a kg, in effect taking 2 rs from you for every kg of grain you buy. On the other hand subsidy under PDS would reduce price of grain from 10 rs to say 2rs in effect transferring 8 rs to your pocket. In this way, they are converse of indirect taxes.

When government directly transfers money in your bank account without any condition i.e. unconditional direct benefit transfer, subsidy becomes converse of direct taxes.

In India government (central and state) subsidize a lot of things from food to fertilizer to kerosene and LPG etc. Tax concessions can also be considered as implicit subsidy. Subsidies increase government spending and thus puts pressure on government finances.

So what’s the rationale for subsidy?

Like indirect taxes, subsidies can alter relative prices and budget constraints and thereby affect decisions concerning production, consumption and allocation of resources.

So purpose of subsidies is two fold-

1. Increasing consumption of items government considers important such as health, education, nutritious food etc or renewable energy in modern times.
2. Redistributive effect i.e. to provide minimum level of protection to the poor <welfare function, tax the rich, distribute in poor>

For objective one to be fulfilled government should subsidize merit goods.

What are merit goods?

A good which would be under-consumed (and under-produced) in the free market economy

But why are they under-consumed?

They are associated with positive externality i.e. they also benefit public but since consumers and producers will take account of only private benefits, they are likely to consume less than desired. For instance, consider education, not only a person is educated and earns more <private benefit> but more productive individual would also benefit society in the form of higher taxes <societal benefit> 

For objective two (redistribution) to be achieved, subsidies should be well targeted i.e. reach the poor with minimal leakages. This requires proper targeting without which there would be inclusion errors (rich getting subsidy and exclusion errors (poor not getting subsidy). Exclusion errors are the worst since they direct affect the poor <kerosene meant for poor not reaching him, how will she light her house>

Subsidy rationalisation is this process of better targeting to weed out unintended beneficiaries as well as phasing out subsidies on non merit goods.

So, what are the adverse consequences of bad subsidies (non merit, not well targeted)?

1. Fiscal effects– directly increase fiscal deficit and thus total government debt <10% of total govt spending is for subsidies> <While golden rule of borrowing is, borrow to invest >
2. Allocative effects– result in inefficient resource allocation <producers will produce more of subsidized good even when not required>
3. perverse distributional effects endowing greater benefits on the better off people <subsidized diesel being used to run SUVs>
4. Shortages and black marketing <subsidized urea being diverted to non agricultural uses, scarcity leading to black marketing harms the poorest farmers the most>
5. Tendency to self-perpetuate. They create vested interests and acquire political hues <Exit problem discussed in economic survey chapter two, click here to read>

For instance, High MSP for wheat and rice and subsidized water and electricity illustrates all such effects, an example of bad bad subsidy.

• Perverse distributional effects– better off farmers of Punjab and Haryana getting benefited<no procurement from eastern belt, poor farmers of Bihar, Jharkhand not getting benefits>
• Fiscal effects– finances of central as well as state govt getting stretched, discoms in debt <high deficit # high debt # high interest cost # high deficit = vicious circle>
• Allocative effects– pulses and oilseeds are not grown resulting in shortages <procurment only of grains, no incentive to produce pulses>
• environmental effect– water table going down, soil getting salty and arid
• Health effect– Groundwater pollution due to high fertilizer use, burning of husks resulting in air pollution

How subsidies distort the market (in a comical way) is best understood by Railway subsidies <Example from last year’s economic survey> 

• Govt subsidizes passenger fares resulting  in losses. Railways cannot generate sufficient internal resources to finance capacity expansion investments;Result-Trains always run late, very slow services, whole economy becomes unproductive
• Of course the passenger fare is cross subsidized by high freight tariffs . It results in diversion of freight traffic to road transport which is costlier. Result- not only financial and efficiency costs but also acute costs associated with emissions, traffic congestion, and road traffic accident (RTA) <And we all know passengers on two wheeler or those walking die the most in the RTA i.e. poorer segments of society>
• High freight cost raises the cost of manufactured goods that all households, including the poor, consume. <subsidized passenger fare but costly goods, no one knows who gains who losses but these distortions decreases the overall efficiency and thus whole economy suffers.>

What’s the solution?

End perverse subsidies while investing in state capacity to deliver basic goods and merit goods such as health, education, skills etc. Incentivize research and development, environment friendly technologies etc. Borrow only to invest. Adhere to FRBM targets of zero revenue deficit.

• Direct Benefit Transfer (DBT) using  JAM number trinity, read the economic survey chapter here
• JanDhan i.e. Bank accounts, Adhar i.e biometric identification and mobile i.e. mobile banking
• It will result in direct transfer of money to bank account of beneficiaries and cut down leakages as intermediaries are removed.
• Biometric authentication will remove ghost accounts i.e same person getting subsidy twice from two different names.
• Mobile banking will give access to bank accounts for easy deposit and withdrawal

But problem of identification of beneficiaries still remains and it requires better and more robust data collection, publishing names of beneficiaries at gram panchayat level for people to raise objections, jan sunwai (public hearing), social audits and such transparency mechanisms

Pitfalls of DBT

1. Where transfers are unconditional, people may just spend money on desi liquor <objective of changing consumption pattern defeated>. For instance, if govt transferred 6000 rs to every pregnant women it’s possible that money will go in the bank account of husband and instead of better nutrition for pregnant lady, he will buy desi liquor.

solution- transfer money in the hand of oldest woman and provide her information so that she can take informed decision in the best interest of family

2. Conditional transfers might give rise to its own kind of corruption. For instance if money is transferred for check up by a nurse, she might demand bribe for certifying you indeed showed up for check up.
3. Private market may not exists for people to buy goods and services from the market. For instance, if PDS shops are closed, where would people buy ration from?
4. Banking infrastructure poor <as we saw in the JAM article, last mile banking access is jamming the JAM>
5. Real value of subsidy amount will be eroded with inflation. solution- link subsidy with CPI inflation. But generally food inflation higher than CPI, then what?
6. There is concern that biometric fingerprinting may not work for rural manual labourers.

• what happens to corporate tax breaks and subsidies going to not so poor?Government decision to phase out corporate tax exemption while simultaneously bringing down tax rates down to 25% level is welcome in this regard.
• It will remove major distortions and end favours to select few corporate groups

Government should rationalize subsidies so they are targeted better and use money thus made available to invest in physical and social infrastructure.In this way by rationalizing subsidies government can bring down fiscal deficit and overall debt level. Bringing fiscal deficit under control, reduces aggregate demand, this cooling down prices.

Now it’s time to solve some previous year IAS prelims questions 

#1. The sales tax you pay while purchasing a toothpaste is a

1. tax imposed by the Central Government.
2. tax imposed by the Central Government but collected by the State Government
3. tax imposed by the State Government but collected by the Central Government
4. tax imposed and collected by the State Government

#2.To obtain full benefits of demographic dividend, what should India do?

1. Promoting skill development
2. Introducing more social security schemes
3. Reducing infant mortality rate
4. Privatization of higher education

#3. In India, deficit financing is used for raising resources for

1. economic development
2. redemption of public debt
3. adjusting the balance of payments
4. reducing the foreign debt

#4. There has been a persistent deficit budget year after year. Which of the following actions can be taken by the government to reduce the deficit?

1. Reducing revenue expenditure
2. Introducing new welfare schemes
3. Rationalizing subsidies
4. Expanding industries

Select the correct answer using the code given below:

(a) 1 and 3 only
(b) 2 and 3 only
(c) 1 only
(d) 1, 2, 3 and 4

#5. With reference to Union Budget, which of the following, is/are covered under Non-Plan Expenditure?

1. Defense -expenditure
2. Interest payments
3. Salaries and pensions
4. Subsidies

Select the correct answer using the code given below.

1. 1 only
2. 2 and 3 only
3. 1, 2, 3 and 4
4. None

#6. Which one of the following is not a feature of “Value Added Tax”? (2011)

• (a.) It is a multi-point destination-based system of taxation
• (b.) It is a tax levied on value addition at each stage of transaction in the production-distribution chain
• (c.) It is a tax on the final consumption of goods or services and must ultimately be borne by the consumer
• (d.) It is basically a subject of the Central Government and the State Governments are only a facilitator for its successful implementation

#7. Under which of the following circumstances may ‘capital gains’ arise? (2012)

1. When there is an increase in the sales of a product
2. When there is a. natural increase in the value of the property owned
3. When you purchase a painting and there is a growth in its value due to increase in its popularity

Select the correct answer using the codes given below :

• (a) 1 only
• (b) 2 and 3 only
• (c) 2 only
• (d) 1, 2 and 3

#8. Consider the following actions by the Government:

• 1. Cutting the tax rates
• 2. Increasing the government spending
• 3. Abolishing the subsidies

In the context of economic recession, which of the above actions can be considered a part of the “fiscal stimulus” package?

A. 1 and 2 only
B. 2 only
C. 1 and 3 only
D. 1, 2 and 3

#9..Consider the following statements:

In India, taxes on transactions in Stock Exchanges and Futures Markets are

• 1. Levied by the Union
• 2. Collected by the State .

Which of the statements given above is/are correct?

A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2

Answers 1-d,2-a,3-a,4-a,5-c,6-d,7-b,8-a,9-a.

To read more conceptual articles related to economy click

Economics Concepts Simpified

Inflation or price rise has been a major concern of policymakers for a long long time. Common man also lists price rise among his top most concerns. Responsibility of controlling price rise lies with government and RBI. But to control something, we need data which tells us direction in which we are moving.

In India, that data or measure of inflation is Wholesale Price Index (WPI) and Consumer Price Index (CPI). But of late both these data sets are moving in opposite direction.

Then are the prices rising or falling? What explains the difference b/w these two indicators? Which one should be used for taking important policy decisions which affect the whole economy? And finally why is inflation such a bad thing and if it were such a bad thing, surely deflation should be great. who wouldn’t like cheap goods! But why is then Japan struggling with precisely such a thing and Eurozone doing its utmost to avoid deflation?

Let’s understand inflation 

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.

Note here the term general price level i.e. increase in price of only 1 or 2 commodities is not inflation but increase in prices of a basket of goods and services.

Let’s understand this with a one commodity economy first-

Suppose in India only apples are consumed and they cost 100 rs a kg in 2010

But suppose both apples are oranges are consumed in India and prices of oranges actually fell from 100 to 95 and then 90.

Inflation in oranges 95-100/100 would be -5%

so general inflation would be 10% + (-5%) = 5% right? If you think so, CSAT mein kamjor lagte ho. Consider this

Here, we introduce the concept of weights. When calculating general inflation, we need to assign weights to different goods and services in the proportion they are consumed and then we take weighted average to compute general inflation.

The year whose consumption level is included in creation of basket of goods and services is called base year, in this case 2010. Base Year has to be frequently revised as consumption basket keeps on changing. For instance, pizza would not have been in the consumption basket about a decade back.

Base Effect

Scenario one,

 in 2012 there is negative inflation while w.r.t to 2010, prices have risen significantly.

Scenario two

In this scenario also prices in 2010 and 2012 are same but due to excessive inflation in 2011 in earlier case, 2012 appeared to be deflationary.  This anomalous situation is being created due to base effect.

What we were calculating till now was price rise in items average citizen consume. Because we are talking about consumers this is called Consumer Price Index (CPI) inflation.

Let’s know more about CPI inflation in India

Base year- 2012

Calculated by – Central Statistical Organization (CSO) in Ministry of Statistics and Programme Implementation (MoSPI) using  Laspeyres formula (basically our weighted average formula)

Basket: 

These broad categories are further divided into subcategories but that’s not important. What is important is that about 46% weight is given to food items and any increase in food prices will lead to increase in CPI inflation.

Other point to note is that health, education etc services are also there in CPI basket. we shall later see services are not in WPI basket and thus CPI gauges services inflation as well.

But food prices are highly volatile as food products can’t be stored for long and prices depend on agriculture output. Also food is an essential good and people will buy food no matter what the food prices are, food inflation is not much affected by central bank policies. It’s a supply side issue.

Similar is the case with fuel prices which are highly volatile.

• When we remove these components from overall inflation, we get core inflation
• Core CPI =Headline CPI MINUS (food and fuel components.)

Why is overall inflation called Headline Inflation?

That is what newspaper headlines report

Because consumption basket of rural and urban areas are different, CPI inflation is calculated separately for rural and urban areas.

CPI (rural) and CPI (urban) both have same 2012 base with slightly different weightage. For instance Rural CPI doesn’t consider Housing inflation. Weightage of food items is about higher in rural areas. Weighted average of CPI(R) and CPI(U) gives overall CPI inflation.

Earlier we used to calculate 4 different categories of CPI inflation

1. Agricultural Labourer (AL)
2. Rural Labourer (RL)
3. Industrial Workers (IW)
4. Urban Non-Manual Employees (UNME)

First 3 computed by Labour bureau, as you can guess and the last one by CSO. We continue to compute these indices but focus now is on CPI (rural), CPI (Urban) and overall CPI

Why is CPI important-

It directly affects what consumers pay to buy a select basket of goods and services. It is thus better indicator of the cost of living and, hence, reflecting the welfare objective of monetary policy.

Let’s now take a look at Wholesale Price Index (WPI) inflation.

As the name suggests it computes price rise at the level of goods and services sold at wholesale level

Base Year : 2004

Calculated by Economic Adviser in the commerce ministry using same Laspeyres formula

Basket 

Primary Articles include food, non food and minerals

Weightage of food items in WPI is weightage of primary food articles (cereal, pulses etc) + weightage of manufactured food items (ice cream, ghee, butter etc)

14% + 10% = 24%

• Core WPI  ignore Food and Fuel (volatile components)
• Core WPI is WPI of Non-food manufacturing industries
• Core WPI = Headline WPI – (primary + fuel + food mfg. industries)

Note here that WPI does not take into account inflation in services sector such as education, health etc. while 65% of our GDP comes from services sector i.e. it does not give complete picture of price rise in the economy.

In spite of that, RBI used to focus on WPI earlier as CPI basket and base year was not frequently revised and data set was not robust but after the signing of monetary policy framework RBI has decided to focus on CPI as it directly affects consumers and thus better indicator for policy formulation.

But if RBI is to focus on CPI only, what’s the importance of WPI and why so much divergence with WPI in negative and CPI 5% in positive.

1. Statistical difference –

• inclusion of services in CPI
• Different weightage to different items with food occupying highest weightage in CPI and food inflation being higher
• While reduced crude prices leading to negative WPI

2. Transaction costs – Middlemen might have increased their profit margin

3. Taxes – Indirect taxes 

If same item has higher inflation in CPI than WPI, possible reason could be higher margins and govt can target that area to bring down inflation.

Other measure of inflation is GDP deflator which we understood in this article

What is Produce Price Index (PPI)

PPI is inflation at producer level without any tax component

Advantage of PPI over WPI

• Majority of the OECD countries measure inflation based on PPI (International Best Practice)
• WPI includes taxes while PPI tracks inflation minus tax component
• PPI will track average change over time in selling prices received by domestic producers for their output for both goods and services while WPI tracks transaction only at the wholesale level for goods.

Govt set up a committee headed by Professor BN Goldar to devise PPI.

Earlier two separate groups headed by Abhijit Sen and Saumitra Chaudhuri underscored the importance of PPI but felt that more work and data was needed to fully construct PPI.

Let’s understand some other terms associated with inflation

Deflation- Opposite of inflation i.e. general decline in prices. it is generally associated with contracting economy i.e. recession and is much more dangerous than inflation.

Disinflation-Slow down in the rate of inflation i.e. prices are still rising but as the lower pace. Eg. If inflation rate was 10%, 2 years back, 8% last year and, 6% this year, economy is said to be in disinflation.

Hyperinflation– Very high and accelerating inflation which cause people to severely curtail their use of the currency as currency simply becomes worthless. For instance in Germany after 1st world war or in Zimbabwe a few years back. Prices rise 10% or more month on month.

Stagflation- 

stagnation plus inflation i.e. inflation in a stagnating economy. Generally inflation is associated with a booming, high growth economy but when economy is contracting, growth rates are coming down, unemployment is rising and there is high inflation , it is called stagflation.

What are the causes of inflation?

Essentially there is more amount of money to buy limited amount of goods and services leading to rise in prices (demand supply mismatch). It could be due to following reasons-

1. Demand pull inflation –  increases in aggregate demand due to increased private and government spending. Thus high fiscal deficits, high subsidies lead to demand pull inflation.
2. Cost push inflation– also called “supply shock inflation,” is caused by a drop in aggregate supply. This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Another example could be inflation due to high administered prices due to high MSP.

Monetary policy can mainly control demand pull inflation by raising interest rates, tightening liquidity thus reducing amount of money available. Supply side inflation is difficult to control by monetary authorities and in case of India main cause of inflation is high food prices which is a supply side issue due to rigidities in agriculture markets. Then why does RBI raise interest rate when inflation is due to supply side issues such as high food prices? 

Here comes the role of 3rd factor-

3. Built in inflation is induced by adaptive expectations, and is often linked to the price-wage spiral. Essentially workers try to keep their wages up with prices (above the rate of inflation), and firms pass these higher labor costs on to their customers as higher prices, leading to a ‘vicious circle’.

RBI raises rates to break this vicious circle.

For this very reason, RBI conducts survey of inflationary expectations and latest surveys suggest in spite of inflation being down to 5%, expectations are of double digit inflation due to very high inflation for a prolonged period.

Let’s now understand effects of inflation 

General Effects –

1. As same amount of money buys less goods, purchasing power of currency comes down, currency depreciates in international exchange rate market. How? Learn here
2. It benefit borrowers or debtors as in real terms they have to repay less amount in real terms while it hurts creditors or savers.

You can clearly see, borrower/ debtor has to return less in real term, thus advantage debtor/and disadvantage creditor / bond holder.

Negative effect-

• Uncertainty about future rate of inflation makes it difficult to conclude business deals, affects investment.
• Savers tend to park their money in fixed assets, financial savings fall. One of the reason for gold rush in India was high inflation.
• Hurts poor the most as they are not able to bargain for higher wages to keep up with the rising prices
• Hoarding– to take advantage of higher prices in future, this furthers inflation and vicious cycle starts. Recall the case of pulse hoarders when pulse prices were shooting up.
• Finally there is always that risk of inflation going out of control resulting in hyperinflationary situation which can cripple the whole economy

Positives

1.Most important positive is that it avoids deflationary tendencies which is the worst

Effects of deflation

1. As we saw above, it harms borrowers resulting in inability to repay loans. Companies and banks collapse
2. While in inflation people start hoarding, here people postpone their purchases in the expectation of future fall in prices. If nobody buys, demand goes down and economy goes under recession resulting in job losses and high unemployment

2. Labour-market adjustments- Nominal wages are slow to adjust downwards. Since inflation allows real wages to fall even if nominal wages are kept constant, moderate inflation enables labor markets to reach equilibrium faster.

Consider this, real salary has decreased but person would feel he had been awarded 8% pay hike.

But if there were no inflation, he would have resisted wage decline, though it would have been same, worth 9 kg apples.

In emerging economies such as India, structure of economy changes rapidly and thus more frequent churning and adjustment in labour market is required. It is for this reason that inflation level of 4-6% is considered healthy in emerging economies while most advanced economies don’t like inflation beyond 2%.

Inflation especially demand pull inflation is associated with high growth and low unemployment. As demand rises, industries increase their production leading to higher growth and employment. This holds true only for short term.

A few more terms before we wind up our discussion –

Phillips curve is a historical inverse relationship between rates of unemployment and corresponding rates of inflation.

Misery index – the sum of the inflation and unemployment rates

Modified misery index – sum of the interest, inflation, and unemployment rates, minus the year-over-year percent change in per-capita GDP growth

In the next article we shall discuss tools available with government and RBI to control inflation and why monetary policy transmission is very poor in India.

Now it’s time to solve a few questions asked in previous years IAS prelims-

#1. Which of the following brings out the ‘Consumer Price Index Number for Industrial Workers? (IAS pre 2015)

• (a) The Reserve Bank of India
• (b) The Department of Economic Affairs
• (c) The Labour Bureau
• (d) The Department of Personnel and Training

#2. A rise in general level of prices may be caused by

1. an increase in the money supply
2. a decrease in the aggregate level of output
3. an increase in the effective demand

Select the correct answer using the codes given below.

1. 1 only
2. 1 and 2 only
3. 2 and 3 only
4. 1, 2 and 3

#3. Consider the following statements: (IAS Pre 2014)

1. Inflation benefits the debtors.
2. Inflation benefits the bond-holders.

Which of the statements given above is/are correct?

1. 1 only
2. 2 only
3. Both 1 and 2
4. Neither 1 nor 2

#4. India has experienced persistent and high food inflation in the recent past. What could be the reasons?(2011)

1. Due to a gradual switchover to the cultivation of commercial crops, the area under the cultivation of food grains has steadily decreased in the last five years by about 30%.
2. As a consequence of increasing incomes, the consumption patterns of the% people have undergone a significant change.
3. The food supply chain has structural constraints.

Which of the statements given above are correct?

• (a.) 1 and 2 only
• (b.) 2 and 3 only
• (c.) 1 and 3 only
• (d.) 1, 2 and 3

#5. A rapid increase in the rate of inflation is sometimes attributed to the “base effect”. What is “base effect”?(2011)

• (a.) It is the impact of drastic deficiency in supply due to failure of crops
• (b.) It is the impact of the surge in demand due to rapid economic growth
• (c.) It is the impact of the price levels of previous year on the calculation of inflation rate
• (d.)None of the statements (a), (b) and (c) ‘given above is correct in this context

#6. Economic growth is usually coupled with (2011)

• (a.) Deflation
• (b.) Inflation
• (c.) Stagflation
• (d.) Hyperinflation